Saturday, May 30, 2009

About The Concept Of Opportunity Cost

In this post, I mention that I disagree with George Reisman on the issue of opportunity cost, something which reader Wladimir Kraus challenged me to elaborate upon.

First of all, it should be said that opportunity cost is in many aspects not cost in the same sense as other costs. Which is to say it does not mean a reduction in wealth, unlike other costs. Opportunity cost represents foregone increase in wealth, rather than a reduction in it. However, it is relevant as a factor in human action and therefore also in economic analysis.

This can be illustrated by this conversation between Homer and Marge in the Simpson's episode "Lisa's rival" where Homer had acquired a large amount of sugar and thereafter decided to stop going to his job at the nuclear power plant and instead start a career as a sugar salesman, a choice that Marge expressed strong disapproval of:

"Homer: And you didn't think I'd make any money. I found a dollar while I was waiting for the bus." [Homer triumphantly shows the one dollar bill he found for Marge]
Marge: While you were out earning that dollar, you lost forty dollars
by not going to work. "

So who was right, Homer or Marge? If you reject the concept of opportunity cost, you would have to say that Homer was right in his decision to sell sugar instead of working at the nuclear power plant. He did after all make a dollar.

But really, of course Marge was right. From a pure cash flow perspective, doing a job that earns you a dollar instead of one that makes you forty dollars, is in fact a choice that is associated with a thirty nine dollar cost. While that doesn't mean that Homer had a $39 negative income, it did mean that this choice cost him the additional thirty nine dollars he would have earned if he hadn't substituted his nuclear power plant job for his suger salesman job. Meaning that it was a bad choice unless Homer enjoyed that job task for a value of $39 or more relative to the job task he had at the nuclear power plant.

The concept of opportunity cost also has many important tasks with regards to economic analysis. A good example is the issue of why money demand is negatively correlated with the level of interest rate. Without the concept of opportunity cost there is no reason to expect that. But if you realize that holding cash and accounts that don't pay interest, has a opportunity cost compared to the alternative to investing it in interest bearing accounts, then you realize that because lower interest rates means a reduction in the opportunity cost of holding money, lower interest rates will increase money demand.

Reisman offers the following objection to the concept of opportunity cost: I
magine a person could spend $1 million buying stock A or stock B at $10 a share, and he decides to buy 100,000 shares of A. Next, stock A's price rises to $20 and stock B's to $30. If that person were not informed abou$t opportunity costs, he would think he had made $1 million. But, writes Reisman, "If one believes the opportunity-cost doctrine, this is grounds for leaping from the nearest skyscraper — one has lost a million dollars"

Well, if you still have $2 million I don't think financial problems justify suicide. That consideration doesn't justify rejection of the opportunity cost concept either. Warren Buffet for example lost, not just in the sense of missed opportunities, but in a very strict sense some $25 billion during 2008. But since he still had $37 billion, his financial problems clearly aren't a reason for suicide. Reisman's example really doesn't prove anything.

Clearly though, you would still regret the decision to invest in the stock that rose just 100% instead of the stock that rose 200%, similarly to how Warren Buffet presumably regrets the decisions that caused his $25 billion loss.

So, while opportunity cost may not be a cost in the sense that costs are represented in business accounting, it is a cost in a praxeological sense, which is to say in terms of how it affects human behavior. It is therefore a valid concept in economics.

10 Comments:

Blogger Wladimir Kraus said...

I think Stefan has missed Reisman's point. For one, Reisman explicitly says (pp. 450-460) that it is better to have a bigger financial gain than a smaller one. In that sense, Reisman would agree with Marge but still reject the concept of opportunity cost as a valid construction in economics.

Secondly, please keep in mind that the concept aspires to be more than merely a clever way to say that people prefer to have more than less and tend to adjust their actions accordingly.

An economic concept is supposed to help process, organize and integrate our knowledge of economic phenomena. Reisman shows that OC renders integration virtually impossible by making the meaning of what cost is so elastic as to be entirely meaningless, thus creating enormous confusions and obvious absurdities.

The doctrine supports and encourages the creation of entities, here costs, virtually out of thin air -- by the power of a whim, where there are none in actual fact. Economists routinely use OCs to embrace not only foregone monetary benefits, such as a foregone profit from selling a good, but also purely "psychic" costs such as the foregone pleasure of not spending one's time with friends if one chooses to work, for example.

By doing so, the doctrine prevents a clearer understanding of the precise nature of the relationship between costs, revenues, profits etc. in the economic system. It is important to note that the section of "Opportunity Cost" in Reisman's book Capitalism: A Treatise on Economics is written in the context of his discussion of the concept of productive spending in a division of labor system and how and why it must be distinguished from consumptive spending.

Briefly, *only* the category of productive spending, which Reisman defines as the expenditure to buy capital goods and hire labor services for the purpose of making subsequent sales, can give rise to costs of production. To see this, imagine there is no productive expenditure in the economic system. The only category of spending present is spending on consumers' goods.

What would that situation mean economically? In terms of "mere" accounting, no costs of production of account of either capital goods or labor services would be present. Zero costs anywhere in the economy means a primitive economic system. Only if people act capitalistically, i.e. buy factors of production in order to sell the product on the market for (money) profit, not for their own use, can division of labor develop and economic progress commence beyond the primitive level of tribal production/exchange.

But one won't be able to recognize all that if one reasons from the point of view of opportunity cost doctrine. One will fail to recognize the pattern between low costs of production and higher profits if one reasons from the point of view of opportunity cost doctrine. One will be at a loss to understand what determines the amount and the rate of profit, how they relate to productive vs. consumptive expenditures if one reasons from the point of view of opportunity cost doctrine.

All that, plus, as Reisman shows exhaustively in the section, the obvious absurdities implied if one thinks through the logic of OC which speak very strongly, in my opinion, against the use of OC a a viable tool of economic analysis.

10:21 PM  
Blogger Per-Olof Samuelsson said...

I have a question for Stefan: If you disagree with Reisman's criticism of "opportunity cost", then what is your view on the preceding section (p. 459f) on "imputed income"? I ask this, because the criticism of those two doctrines is basically the same - namely that they both introduce incomes and costs that are fictitious.

4:54 PM  
Blogger Per-Olof Samuelsson said...

There's an expression in Swedish when someone is looking very frustrated: "You look like you have sold the butter and lost the money".

Well, if someone has sold his butter for x kronor and then - by having a hole in his pocket, or having been robbed at his way home, or whatever - having lost the money, he has of course suffered a loss of x kronor.

But suppose this person hasn't bothered to sell his butter at all, but has instead used it to butter his own bread. Isn't it true that according to the OC doctrine, he should still feel as frustrated, since he has obviously failed to earn those x kronor?

(I hope this comment is not too flippant...)

11:44 PM  
Blogger Wladimir Kraus said...

Good point about imputed income! I think it is important to emphasize that it is the certain conception of things that gave rise to both the doctrine of opportunity cost and the imputed doctrine. If instead one focuses on either OC or imputed income in isolation, the problematic nature of the ideas behind them will not be appreciated at all. Only if the problem is recognized in its range and depth, a proper appreciation of the special case of OC can be possible and fruitful.

I believe the reason why the adherents of OC doctrine are having such a hard time accepting Reisman's criticism is that they are stuck within the "older" framework. That older framework embraces not only the neoclassicals but Austrian economists as well (remember that it was Wieser who coined the term and developed economic implications of the concept.). Within that framework the concept of OC makes perfect sense. Indeed, it is quite central to its conception of what are costs, prices, incomes, capital, savings, capital goods etc. etc.

Reisman's absolutely revolutionary contributions to this and other issues and problems in economics consists first and foremost in the fact that he takes the nature of entities and their connections to reality very seriously. For example, it is common under economists to casually refer to everything unpleasant or involving the choice of foregoing something as "cost". The problem is that when a concept is so elastic as to include virtually everything under the sun and which is changing all the time in accordance with the changing caprices of the human race, it becomes virtually impossible to employ it in the efforts of integrating it with other concepts, to relate the concept "cost" to other market phenomena, to understand in precisely what manner they are connected and interconnected. The same criticism applies to concepts revenue, income, capital (just think about the super-elastic concept of "human" capital) and so forth.

We have to judge the concepts according to their utility and robustness in scientific investigations. Upon closer examination, after an appropriate "stress test", as it were, OC must be found grossly inadequate as a tool for economics analysis.

12:21 AM  
Blogger Gene Callahan said...

The reality of opportunity costs has nothing whatsoever to do with how someone should "feel" after eating butter or investing in the wrong stock!

11:32 AM  
Blogger Gene Callahan said...

"Reisman's absolutely revolutionary contributions to this and other issues and problems in economics consists first and foremost..."

in reverting to ideas discredited over a century ago!

11:33 AM  
Blogger Wladimir Kraus said...

It's great to see Mr. Callahan commenting on Reisman's work. I, at least, would benefit from more specific criticism.

Specifically, it would be great if Mr. Callahan would just list the "discredited ideas"? Would he include J.S. Mill's "demand for commodities is not demand for labor", the wages fund doctrine, or Ricardo's comparative advantage in the list of those discredit ideas? But what about the Ricardo effect, so prominent in neoclassical economics and in Hayek's work? Does Mr. Callahan think the Ricardo effect is valid?

Re definition of opportunity cost. Would Mr. Callahan accept this definition: "The opportunity cost of a decision
consists of the things that are given up by taking that
particular decision rather than taking an alternative decision."?

Thanks!

10:00 PM  
Blogger James said...

I doubt Professor Callahan will respond, so I will do my best in his stead. Opportunity cost is perhaps the hardest concept in all of economics to understand. In fact, Robert Frank, an economist at Cornell University has done research that suggests that many professional economists don't quite get it. Somewhat arrogantly, I think I have got it down pretty well.

The best way to think of the concept of opportunity cost is not as a doctrine (there are no policy implications or anything like that) or even as a theory (it is not falsifiable). Opportunity cost is a framework to help people make decisions. It is a way of looking at the world.

Opportunity cost is what you have to give up to get something. It is not a financial cost, and no one has ever paid it. It will not show up on a balance sheet, and it is not added or subtracted from profit. If you think about opportunity cost as a financial idea, you will just get confused.

A major source of confusion in this conversation is applying opportunity cost to probabilistic events. If you buy the wrong lottery ticket, you don't suffer an opportunity cost of $10 million dollars. The option to win the lottery was never really yours to give up. You have to be able to give something up for it to be an opportunity cost. Since you don't know beforehand what stocks are going to be worth, it makes no sense to look back on the past and constantly second guess your investments.

Kraus - "The doctrine supports and encourages the creation of entities, here costs, virtually out of thin air -- by the power of a whim, where there are none in actual fact. Economists routinely use OCs to embrace not only foregone monetary benefits, such as a foregone profit from selling a good, but also purely "psychic" costs such as the foregone pleasure of not spending one's time with friends if one chooses to work, for example."

Opportunity costs are created whenever decisions are made. They are created out of thin air, simply by the fact that there are alternate uses to resources, time and effort. Homer's job at the power plant was "thin air" because he never did it, instead selling sugar. OCs are the net (normal benefit - costs) of the best alternative the economic actor does not do. Psychic costs are included in this because they influence people's decision making. To exclude psychic costs would be wrong because people really do act on those costs.

Hopefully this comment has been insightful. I know it's a long long time after the original post.

10:28 PM  
Blogger Wladimir Kraus said...

James,

thanks for your input and interest in the subject! Your post does indeed show that you try hard to come to grips with the problem and seek a solution, which is great!

If you're willing to consider Reisman's side of argument seriously, please consider carefully the relevant passage in his treatise "Capitalism." For one, he doesn't deny that people indeed employ a heuristic that you quite accurately describe. Rather, the problem is, as I wrote in my first comment to Stefan's post:

"... [p]lease keep in mind that the concept aspires to be more than merely a clever way to say that people prefer to have more than less and tend to adjust their actions accordingly.

"An economic concept is supposed to help process, organize and integrate our knowledge of economic phenomena. Reisman shows that OC renders integration virtually impossible by making the meaning of what cost is so elastic as to be entirely meaningless, thus creating enormous confusions and obvious absurdities."


I hope you'll find the time to read Reisman on OC and consider to what extent the concept of OC really helps us understand the economic laws of a division-of-labor economic system.

Thanks!

11:51 PM  
Blogger Xerographica said...

"to what extent the concept of OC really helps us understand the economic laws of a division-of-labor economic system."

Consumers are forced to consider the opportunity costs of their spending decisions...donors are forced to consider the opportunity costs of their donations...but taxpayers are not forced to consider the opportunity costs of their taxes.

What's the opportunity cost of taxpayers not being forced to consider the opportunity costs of their taxes? Efficiency, freedom and the warm glow effect.

Economists really love efficiency so it's really strange that no economists have advocated that donations to government organizations should be 100% tax deductible...aka pragmatarianism.

If donations to government organizations were 100% tax deductible then the resulting division of labor between taxpayers would reveal the ideal division of labor between the private and public sectors.

2:12 PM  

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